Supreme Court Urged to Approve Scheme Liability in Securities Fraud Actions

Although the SEC and DOJ did not file an amicus brief in the scheme liability case now before the Supreme Court, a number of other entities did, including the state securities administrators association, the council of institutional investors, state attorneys general, and eminent law professors.

In the case of Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. (No. 06-43), the Court is slated to determine whether secondary actors, such as investment banks and auditors, that knowingly commit securities fraud can be held liable for their actions. The briefs addressing this question, a concept known as scheme liability, were filed in support of the investors in the Stoneridge case.

The battle over scheme liability is joined when investors argue that an investment bank or auditor need not have made misleading statements or omissions to be liable for securities fraud since participating with scienter in a sham transaction with no legitimate business or economic purpose should suffice. The countervailing argument is that the actors must make a misleading statement to be held liable under Rule 10b-5; and thus scheme defendants who remain silent and owe no duty of candor to investors are categorically exempt.

The circuit courts are split on this issue. The Ninth Circuit articulated a test under which participants in schemes with the principal purpose and effect of defrauding investors are held liable whether or not they made misleading statements to investors. By contrast, the Eighth Circuit in Stoneridge and the Fifth Circuit in Enron have adopted what amici contend is a narrow interpretation of scheme liability based on an erroneous interpretation of the Supreme Court’s 1994 decision in Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164.

Amici contend that the broader standard is proper because the plain language Rule 10b-5 reflects a congressional purpose that defendants should be immune from scheme liability when they possess the requisite intent to deceive and actually engage in conduct that does in fact deceive investors. The entire system of monitoring and eliminating securities fraud would be severely undermined if the securities laws allow culpable individuals or companies actively participating in fraud schemes to escape liability for their actions.

In its brief, the North American Securities Administrators Association argued that a decision that holds all parties accountable for their role in a fraudulent scheme, regardless of whether their deception was perpetrated through words or deeds, will help repair the damage done to investors and deter future violations. At a time when large scale financial fraud shows little sign of abating, NASAA urged the Court to ensure that injured investors have the opportunity to seek relief in federal court.

Several of the nation’s foremost academic experts in securities law, including Professors James D. Cox, Jill E. Fisch, and Donald C. Langevoort, explained in their brief that, without scheme liability, market integrity will suffer and victims will too often be left without recourse. Unless investors can recover from any person who engages in deceptive sham schemes, they argued, market integrity will suffer because centrally and recurrently involved third party schemers will face far weaker disincentives to avoid participating in sham transactions which they know are at the heart of a company’s fraudulent misstatements. In some cases, where the company making misstatements is insolvent, such active schemers will be the only source of recovery.

Attorneys General representing more than 30 states pointed out in their brief that without scheme liability many defrauded investors would have no redress. Eliminating scheme liability for what the state officials called ``non-speaking actors’’ will significantly diminish victims’ right to compensation under the securities laws. They pointed out that virtually all of the record $7.1 billion settlement to investors in Enron came from such non-speaking actors…Without those funds, many individual Enron shareholders would have received nothing; and without scheme liability, many more defrauded investors will receive nothing.
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The Council of Institutional Investors, which represents more than 130 public, labor and corporate pension funds, stated that the adoption of the strict test for primary liability would undercut lessons learned in the aftermath of recent financial scandals regarding the complexity of securities fraud today and the importance of deterring secondary actors from participating in fraud. It would give accountants, investment bankers, lawyers, and other third parties a safe harbor for fraud so long as they do not publicly announce their involvement with an issuer’s misstatements. Contrary to the reasoning of some courts, the strict test is not required to stem a tide of frivolous litigation against secondary actors. Finally, the Council emphasized that neither lawsuits against issuers themselves nor SEC enforcement will adequately compensate investors in the face of the strict test.